The benchmark problem

RBI's move can have unintended consequences

The Reserve Bank of India (RBI) on Wednesday made it mandatory for all banks to link new floating-rate loans — to retail customers and micro, small and medium enterprises (MSMEs) — to an external benchmark from October 1. The external benchmark could be the policy repo rate, yields on three- and six-month treasury bills, as published by the Financial Benchmarks India Private Ltd (FBIL), or any other benchmark rate published by FBIL. Borrowers with a floating rate loan who are eligible to prepay without pre-payment charges can also switch to the external benchmark. Evidently, the move is aimed at ensuring a better transmission of monetary policy. Theoretically, the RBI diktat should lead to better transmission because banks would be required to reset rates at least once in three months.

 
However, the move could have unintended consequences. For instance, it may not translate into a big relief for borrowers in the immediate short run. Since banks have rightly been allowed to charge a spread over the benchmark, they would want to cover all risks and costs associated with lending. If the spread is high, though it would reflect the change in the benchmark over time, lending rates could remain at reasonably higher levels. To be sure, the issue of slow transmission is not new. In 2003, the system was moved from the prime lending rate, which was introduced in 1994, to the benchmark prime lending rate. Then in 2010 to the base rate system and, later, to the marginal cost of funds-based lending rate system in 2016. Since internal benchmarks did not help improve transmission as desired, the RBI has now moved to external benchmarks.

 
However, in the present context, it is important to understand why transmission is weak. The Indian banking system is struggling with high non-performing assets and intends to protect margins. In a competitive environment, with a reduction in the cost of funds, banks should reduce rates to attract borrowers and expand their balance sheets. It is not that banks are making excessive profits by charging higher rates of interest. Poor transmission, therefore, reflects friction and inefficiency in the system. Also, a higher fiscal deficit and a large borrowing by the government affect the transmission of policy rates. The central bank, for instance, did open market operations worth about Rs 3 trillion in the last fiscal year to ease liquidity in the system. 

 
Nonetheless, now that the regulator has imposed external benchmarking, the banking sector might face additional pressure, at least in the short term. It is possible that banks will also have to link deposit rates to an external benchmark to protect their interest margins. It is not clear how Indian depositors would react to, say, a reset of fixed deposit rates every three months. The move to an external benchmark will increase interest rate risk for both the customer and banks. There can be situations when policy rates are set high—if banks automatically move up rates in tandem, borrowers can find themselves in serious difficulty. The RBI needs to keep in mind that rates can go both ways. While banks would be in a better position to hedge, risk-averse retail depositors may look for other avenues, such as small saving instruments, which may not allow banks to freely set deposit rates. Consequently, margins can come under pressure and, since the bulk of the banking system is state-owned, it would have fiscal implications. It is not obvious that these unintended consequences have been thought through. A better option would have been to allow banks to freely move to an external benchmark that would have given them the time for necessary adjustments.